BIS paper: Euro repo market functioning: collateral is king

Repo markets play a major role in redistributing liquidity and collateral between financial institutions. A unique transaction-level database reveals how the euro-denominated repo market has performed since the mid-2000s. We find that the market recovered strongly from periods of intense stress, even though it remains segmented according to the home country of the collateral used. In recent years, signs of segmentation have increased as the main motivation of repo market participants has shifted from funding to the trading of collateral.

As a key component of the money market, the repo market is a major channel for circulating cash and collateral through the financial system. Since the mid-2000s, repos have grown to become the predominant source of short-term funding in euro-denominated markets. In this period, the market has weathered stress during the Great Financial Crisis (GFC) of 2007-09 and the European sovereign debt crisis of 2011-12, and has coped with changes such as the ECB’s introduction of unconventional monetary policy and the advent of new financial sector regulation. This article tracks the repo market’s functioning in the face of these developments.

We use a unique transaction-level data set for centrally cleared euro-denominated repos to examine the market’s liquidity and pricing efficiency. We find signs that the market is persistently segmented according to the home country of the collateral used. This may impede the redistribution of liquidity. Yet, despite this segmentation, we find that the repo market remained functional during periods of stress: transaction costs stayed low and prices themselves adjusted smoothly to changing fundamentals.

We also find increasing signs that, in recent years, the market has been driven by investors in search of specific collateral rather than investors seeking funding. This feature has strengthened segmentation along collateral lines. Consistent with segmentation, individual participants have “preferred habitats”, in the sense of systematically borrowing and lending against collateral of a given country.

The following section outlines trading activity in the euro repo market over the 2006-18 period. We then discuss how different segments performed in terms of liquidity and pricing efficiency. The third and fourth sections examine the intensity of arbitrage trades across segments and the tendency of market participants to specialise in individual collateral segments. The final section concludes.

The full paper is available at https://www.bis.org/publ/qtrpdf/r_qt1912k.htm

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